Answers to End-of-Chapter Questions
Chapter 5, Part A
1. The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its
demand and raises its interest rate relative to that on the Baa bond.
2. U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently,
the demand for Treasury bills is higher, and they have a lower interest rate.
3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds,
which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their
risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and
falling during booms.
4. True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the
interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out
of line. The closer in maturity two bonds are, the closer substitute one is for another.
5. If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term
bonds would equal zero and we would be more willing to accept the pure expectations theory.
7. The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected
to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected
short-term interest rates in the near future are above the current short-term interest rate. The downward slope for
longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk
premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only
if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates f